Under The Hood: Exploring Yield With CSJ And FLOT

As market yields have declined in the past year, investors have looked for new ways to build yield into their portfolios. That trend has spurred investor interest in investment grade debt, especially shorter maturity debt that has less interest rate sensitivity.

Today, I want to take a closer look at two short maturity corporate bond funds: The iShares Barclays 1-3 Year Credit Fund (NYSEARCA:CSJ) and the iShares Floating Rate Note Fund (NYSEARCA:FLOT). Investment grade credit bonds generally provide higher yields than comparable maturity Treasury securities, in return for the investor taking on credit risk. Credit risk is a broad term that describes the likelihood that an issuer will not be able to pay back debt.

(The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by visiting iShares.com. For standardized performance, please click on the tickers above.)

First, the basics. Both funds invest in short-term investment grade bonds. CSJ invests in fixed rate coupon bonds with 1-3 years remaining to maturity. FLOT invests in bonds that have less than five years remaining to maturity, but that also have a floating rate coupon. The majority of the bonds in FLOT have a coupon rate that re-sets every three months. So both funds have exposure to credit risk, and the level of credit risk is fairly similar.

The big difference is the amount of duration, or interest rate risk, that the two funds have. CSJ has more interest rate risk, as measured by its duration of 1.83 years. FLOT by comparison has a duration of only 0.10 years. As a result, the price movements in FLOT will be impacted primarily by changes in credit risk, while CSJ will be influenced by both credit risk and changes in interest rates.

Let’s now look at composition. These pie charts show the sector breakdown of each fund:

Source: BlackRock as of 12/30/11. Holdings are subject to change.

As you can see, industrial bonds make up the largest segment of CSJ, followed by financials and non-corporates. The composition of FLOT is a bit different. The majority of the issuers of investment grade floating rate notes are firms in the financial industry and, as a result, that sector makes up 60% of the fund. Industrials and non-corporates are the two next largest categories.

Which one should an investor use? It depends on what they are looking to achieve.

Both funds offer yields above those found in similar maturity Treasury securities, in return for taking on some credit risk. FLOT is more of a pure play on credit risk, while CSJ involves taking on both credit and interest rate risk. Falling interest rates will likely benefit CSJ more, but by the same token the price of CSJ will likely fall more if interest rates rise. Also, FLOT has more exposure to financial firms while CSJ is more broadly diversified across the investment grade market. As a result, unusual performance in bonds from financial companies will likely have more of an impact on CSJ.

The key, as always, is to decide what risks you are comfortable taking and then select the fund that offers that market exposure.

Diversification may not protect against market risk.

Bonds and bond funds will decrease in value as interest rates rise.The funds are subject to credit risk, which refers to the possibility that the debt issuers will not be able to make principal and interest payments. Securities with floating or variable interest rates may decline in value if their coupon rates do not keep pace with comparable market interest rates. Narrowly focused investments typically exhibit higher volatility and are subject to greater geographic or asset class risk. The iShares Floating Rate Note Fund’s income may decline when interest rates fall because most of the debt instruments held by the Fund will have floating or variable rates.

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